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What do you do with your last dollar when you are flat broke? You might as well buy a lottery ticket. Putting your last silver dollar into the slot machine with a million-dollar payout is a rational decision after you’ve gambled away your whole stake. Absent a miracle, you’re going to walk home anyway.
Two great upheavals took place in the past week. One occurred in American politics, when the voters of South Carolina crushed the predictions of the political professionals. The other occurred on the world’s stock exchanges, where the value of the world economy swung in a 20% range.
Senator Barack Obama’s surprise landslide victory in the South Carolina primary demarcates a turning point in modern American politics. Can it be a coincidence that it occurred in the same week that financial markets showed their wildest gyrations in post-war history? Days ago, every poll indicated that economic weakness gave the edge to Senator Hillary Clinton, whom voters regarded as a superior manager. But the Democrats of South Carolina chose a miracle over a manager, for the same rational reasons that a down-and-outer spends his last dollar on the lottery.
Obama’s South Carolina victory speech was the economic equivalent of a carnival snake-oil pitch. He promised to “stop giving tax breaks to rich companies and instead put the money in the pockets of struggling homeowners who can’t pay their mortgages,” and at the same time stop the export of American jobs overseas, while raising everyone’s wages.
The crowd chanted, “Yes we can! Yes we can!” Excuse me: No, you can’t. You can’t keep inefficient American factories open without massive tax breaks to corporations, in the form of tariffs or otherwise. In 1992, voters rejected the same message from Ross Perot, who warned that free trade with Mexico would create a “giant sucking sound” as American jobs disappeared, and chose the free-trader Bill Clinton. But that was then: this is now.
Polls projected a close race, but Obama crushed Clinton by a two-to-one margin. The inability of the pollsters to gauge the opinions of voters is one of the most important observations, for uncertainty itself has become a decisive variable. Can it be coincidence that investors also suffer from the same degree of uncertainty in valuing economic outcomes? During 2008 to date, the Nasdaq 100 Index of American stocks swung in a 26% range. Citicorp , America’s largest bank, gyrated in a 30% range – and therein lies a tale to which I will return momentarily.
If markets cannot make sense of economic outcomes, all the less can individuals at the bottom of the economic pyramid make sense of their own prospects. Americans face a degree of economic uncertainty not seen since the Clinton years, and in some ways much worse, for more Americans than ever will retire during the next decade with slimmer means than they ever expected to have.
People of modest means do not understand the stock market, but they are sly: they can read the panic in the eyes of their leaders. After assuring them for months that all was well, Washington last week offered an emergency interest rate cut for the first time since September 11, 2001, and an emergency economic package which will send a small check to every American family earning less than a certain threshold. Both President George W. Bush and Clinton proposed essentially the same program. If that is “managerial ability,” thought the voters of South Carolina , we might as well buy the lottery ticket.
America faces not a dip in the business cycle, but the end of a 25-year run of wealth creation. Rising home prices were supposed to provide America’s retirement nest egg, the substitute for the savings that Americans never amassed. Home prices have fallen by a third in markets like California, Arizona, Nevada and Florida where the bubble rose fastest. During 2007, the price of American homes fell overall for the first time since the Great Depression. Yet Americans still expect home price appreciation of 5% a year over the long term, according to polls conducted by economist Robert Shiller.
Americans, as I wrote on January 8 (Putin for President … of the United States) mistook the one-time windfall from the Ronald Reagan boom of the 1980s for the enduring right to get something for nothing. Despite massive evidence to the contrary, they still cling to the delusion that twenty years from now, everyone will retire by selling his home to his neighbor at double the price. It is like the passengers on the Titanic selling each other annuities.
Writing about the impending retirement of the Baby Boomers in the January Atlantic Monthly, Megan McArdle observes that prospective retirees evince a preternatural optimism about their prospects. But this confidence “seems to rely on some mystical alchemy of strong stock gains, housing value increases, and government largesse. The first, as we’ve seen, may disappoint. The second seems outright fantastic”.
There is not much to be gained from giving up the illusion that rising home prices will fund the retirement of Americans, for the alternative is to reduce consumption drastically in order to save. It is hard to imagine how Americans can avoid such a shift away from the spending habits of grasshoppers to the thrift of ants during the next several years. But even a very large increase in the savings rate will not match the decline in household wealth due to falling home and stock prices.
It is an ominous sign for the American economy that banks already have taken US$120 billion in charges due to the collapse in the value of securities backed by mortgages of poor (“subprime”) credit quality, before the onset of an actual recession. A number of banks, including Citicorp, America’s largest, are short of capital and have gone hat in hand to sovereign wealth funds in the Middle East and Asia to raise more. To date banks have suffered almost no defaults from corporate borrowers, after the most aggressive round of lending to speculative-grade companies in American history. As defaults pile up during 2008 and 2009, pressure on banks’ capital will become extreme.
Bank capital is the Achilles’ heel of the world economy. Last Monday, stock markets crashed in Asia around one pm local time, when an e-mail from Hong Kong and Shanghai Bank told investors that two of the sovereign wealth funds had pulled out of agreements to investment in Citicorp and other major financial institutions. Whether that is true or not remains unconfirmed, but the rumor alone was sufficient to send world stock markets into a tailspin. Compounding the crisis was concern that insurance companies who have guaranteed $1.6 trillion of securities would not meet their obligations. Investors had assumed that the banks would bail out the bond insurers, but if the banks themselves could not raise capital from the sovereign funds, they themselves would need a bailout before they could bail out anyone else.
No, Obama, you can’t. You can’t blame America’s trading partners for the loss of manufacturing jobs, and at the same time persuade them to replace the misspent capital of the American banking system. You can’t persuade the world to fund hundreds of billions of dollars a year of American home mortgages, and protect the employment of a few hundred workers at Maytag.
Obama well may win the presidency notwithstanding. Some of the decisive electoral battles of 2000 and 2004 were won in the so-called exurbs, the newer and more distant suburbs that mushroomed during the home-building boom of the past decade. Republicans no longer dominate the upwardly-mobile middle class of the exurbs, where the most devastating home-price declines are registered. Earlier this month a large home-builder, Lennar, sold tracts of unoccupied homes in exurban Florida to speculators at 40 cents on the dollar. That does not bode well for the shoddily-wrought McMansions in recently built exurban tracts.
Obama is the “Democratic Reagan,” observes one of my favorite bloggers, Beliefnet’s Rod Dreher. In terms of political punch, the comparison is apt; it is now conceivable that Obama will sweep the November election and bring a Democratic Congress on his coattails. In content, though Obama is the anti-Reagan, promising that the government will come to everyone’s rescue. In his South Carolina victory speech, he proclaimed, “We cannot afford another year without decent wages because our leaders could not come together and get it done.”
What precisely does that mean? “The teacher who works another shift at Dunkin’ Donuts needs us to reform the educational system to raise her pay.” Is the Federal government planning to subsidize teachers’ salaries, which in America are paid by local school boards with city and state taxes? Is he really planning to raise corporate taxes and subsidize mortgage payments?
If Reagan offered “voodoo economics”, as his opponents charged, Obama is selling Cargo Cult economics. After World War II, New Guinea aborigines build model airfields to entice the gods to bring them “cargo”. They watched American soldiers build airstrips and land cargo planes, and sought to accomplish the same through sympathetic magic. Given the culture of the aborigines and their observations, anthropologists aver, making radios and observation towers out of straw and coconuts was a rational response. Something similar might be said of the position of the American middle class.
Waves of uncertainty are whipsawing through both the financial markets and the primary elections. The danger in coming days is that a kind of harmonic resonance will amplify both of them. The Bush administration will cower before Obama’s growing shadow as it struggles to prevent the unraveling of the financial system. Every action to buttress the banks and insurers the administration might take will be vulnerable to the charge that the Republicans are bailing out out Wall Street rather than distressed homeowners or insecure workers. The danger is that election-year politics will paralyze crisis management.
It has been a very long week, and it is going to be a very, very long year.